How strengthening the state’s rainy day fund can help California’s economy

(photo credit: Pliketi Plok)

By calling a special legislative session today to focus lawmakers’ attention on creating a more robust budget reserve, Gov. Brown has demonstrated his commitment to strengthening California’s fiscal condition—and to ensuring the state, with years of double-digit deficits fading into memory, sets aside enough money for the next rainy day.

With the governor’s involvement dramatically increasing the likelihood of action this year, CA Fwd’s report offers a primer on why the rainy day fund has become such a pressing issue for state government—and how it can create the fiscal certainty businesses need to grow. The Report details the unpredictable, multi-billion dollar swings in revenue during the dot.com boom and housing bubble that crippled state services and weakened the state’s fiscal condition. And it outlines the available policy solutions, highlighting four opportunities to strengthen the existing reserve fund—and the governor’s proposed replacement—to better protect state programs. (More on that below.)

Solving for booms and busts

“CA Fwd applauds Governor Brown for calling a special session on the vital issue of building a stronger budget reserve. Calling a special session, where the Legislature can focus solely on this issue in a deep and meaningful way, is a sound strategy to address California's fiscal instability,” says Jim Mayer, president and CEO of CA Fwd. “A Rainy Day Fund is a necessity. The State must adopt a way to capture spikes in revenues and build consistency in savings year in and year out. Californians, especially those who rely on government services like our students, the poor, the elderly, and the sick, should not have to endure deep cuts in service during recessions simply because the State hadn't built up reserves to weather that shortfall.”

The special session will certainly raise the profile of the governor’s proposal, which would put a portion of capital gains spikes into reserve or use it to pay off debt. The session will also draw contrasts with some of the alternatives lawmakers have considered over the last decade: The governor’s proposal, for example, would replace a measure (ACA 4) scheduled for the November ballot that has a different system for capturing non-recurring revenue. ACA 4 itself was crafted in 2010 to replace the state’s existing rainy day fund, a reserve mechanism created in 2004 with the passage of Proposition 58. That measure, which requires the state put three percent of General Fund revenues aside each year, has been criticized for not being strict enough about when deposits should be made—and for not capturing enough money to protect the state budget before the Great Recession arrived.

"We simply must prevent the massive deficits of the last decade and we can only do that by paying down our debts and creating a solid Rainy Day Fund," Brown said in a statement today.

A press release highlighted the details of the governor’s plan, which would:

Increase deposits when the state experiences spikes in capital gains revenues, the state's most volatile tax revenue.

Allow supplemental payments to accelerate the state's payoff of its debts and liabilities.

Raise the maximum size of the Rainy Day Fund to 10 percent of General Fund revenues.

Limit withdrawals to ensure the state does not overly rely on the fund at the start of a downturn.

Create a Proposition 98 reserve to smooth school spending and avoid future cuts. This reserve for schools makes no changes to the guaranteed level of funding dedicated to schools under Proposition 98. In addition, the Proposition 98 reserve would not begin until school funding is fully restored following cuts made during the Great Recession.

Where to go from here—policy opportunities

In Ending the Boom and Bust: How to Build a Stronger Budget Reserve, CA Fwd highlights some of the concerns with two elements of the governor’s proposal, in particular. First, while capturing capital gains revenues may be good policy, these revenues are difficult to identify—and even harder to forecast. A recent LAO analysis found that the actual amount of capital gains revenue is not known until two fiscal years after a decision would have to be made about transferring the revenue into a reserve.

While it may be possible to develop a method to “true-up” the budget and reserve each year to accommodate for capital gains volatility, the report points out that spike revenues alone may not be adequate to develop a suitable reserve. In four years during the 2000s, for example, an LAO analysis found the governor’s mechanism for capturing capital gains (setting aside funds in excess of 6.5 percent of General Fund revenue) would have captured no revenue at all. As a result, no transfers would have been made into the reserve and no funds would be available for one-time purposes like paying down debt.

CA Fwd’s report outlines four broad approaches proposed by fiscal experts for taking on these issues. As lawmakers begin their special session next week, these ideas should be considered in deliberations over how to craft a stronger budget reserve:

1) Strengthen Proposition 58 requirements. Instead of building a new reserve mechanism, the Legislative Analyst’s Office has suggested strengthening the existing budget reserve mechanism (which was created by voters in 2004). In particular, the LAO has pushed lawmakers to consider increasing the size of the reserve and the rules governing the suspension of the transfers from the General Fund to the reserve. The LAO has also proposed alternatives that would focus on a clearer process for withdrawals.

2) Combine fixed transfer amounts and a portion of spikes in revenue. To ensure the long-term stability of the reserve under unpredictable economic conditions, some fiscal experts have suggested a hybrid approach that combines elements of the LAO’s recommendations with the governor’s—combining annual set-asides with a method for capturing unusual spikes in revenue, as well. One way to do this would be to combine a defined transfer from the General Fund—perhaps at a lower rate than the three percent that is in Proposition 58—with an amount that is determined to be non-recurring revenue.

3) Expand the definition of non-recurring revenues beyond capital gains. To identify and calculate revenue for the reserve, the state should consider all of the major sources of income—and not just capital gains. For example, sales and corporate taxes, in addition to personal income taxes, grow faster than personal income during boom times. They could be the basis for identifying extraordinary growth. (Alternatively the revenue growth could be compared to personal income over time.) In addition, it would be technically easier to compare revenue against personal income growth rather than trying to identify in real time how much of the personal income tax is attributable to capital gains realizations.

4) Build a fact-based consensus on when the economy is growing faster than normal. To identify extraordinary spikes in revenue, policy-makers could rely upon an established measure to base an agreement between the executive and legislative branches on the amount of non-recurring revenue. The spike could be certified by the Department of Finance and LAO based on a formula that compares revenues against a denominator reflecting growth in the economy, such as personal income. During periods of fast economic growth—for example, 2005 and 2007—the two branches could be required to agree on an amount of non-recurring revenue to be set aside in addition to the required fixed deposit.